Capital vs. Institutions

The reason some of the poorest countries in the world need microfinance is because deep-rooted institutional problems make the general financial sector unworkable. And until these problems are addressed, we are reduced to celebrating an appallingly small-scale solution to the biggest problem facing humanity today: abject poverty. For the poorest of the poor to make real progress on a global scale, more fundamental changes must be made.

...The poor can't access the larger financial sector because banks in many countries are rewarded for making loans based on political ties, not demonstrated business savvy. And worse, many countries, the Philippines among them, restrict ownership of land and businesses based on membership in racial and ethnic groups. These laws and corrupt practices need to be targeted and a line needs to be drawn in the sand. At the very least big aid donors like the United States need to stop showering millions of dollars on countries that refuse to address these fundamental concerns.

For years, development economists believed that the problem with poor countries was lack of capital. The alternative point of view that has emerged is that what poor countries lack are institutions that allow entrepreneurs to function.

For Discussion. Which is an easier problem to solve--a shortage of capital, or institutional deficiencies?

Arnold Kling also discusses the Daley/Hooks microfinance piece. But the valedictory Kling question poses a false alternative: For Discussion. Which is an easier problem to solve--a shortage of capital, or institutional deficiencies? I think it's increa... [Tracked on February 16, 2005 6:20 PM]

Which is an easier problem to solve--a shortage of capital, or institutional deficiencies?

A shortage of capital is a far easier problem to solve--all it takes to remedy that is money! Read Hernando de Soto's The Mystery of Capital for a great discussion of the problems those institutional deficiencies cause.

The Marshall plan worked because the problem it looked at was essentially "just" a shortage of capital. Western Europe already had the institutions required for development -- they had been developed before WW II.

But the sucess of the Marshall plan caused development economics to use it as a model for development for decade and try to apply that model to areas where the institutions did not exist. This misapplication of the lessons of the Marshall plan probably did massive damage for generations.

It is like the extreme right that says the govt is the problem. In much of the world they are right. No country has ever developed without good institutions that provided good public capital in the form of law, education and infrastructure.

Economic development need both, free markets and good public capital and one alone is not sufficient.

I agree with Jim that de Soto makes many good points in discussing the economics of institutions such as property rights and legal title to property, which exist in attenuated form in many emerging markets. Many of these countries are showered with capital, often loans from multilateral institutions such as the IMF, World Bank, and African Development Bank (often coupled with calls for tax hikes), which are funneled through governments, more than a few of which siphon off funds to maintain their corrupt hegemony and lavish lifestyles.

As The Economist points out in the current issue, much of the multilateral aid goes to repay existing loans. According to Allan Meltzer, loans usually become grants.

Institutional deficiencies keep private capital
scarcer than it otherwise would be, mainly because of a poorly defined and enforced rule of law. Mises, Bauer and other classical liberals emphasized this decades ago.

As for the Marshall Plan, which was basically a subsidy to American farmers, Tyler Cowen wrote a great critique of it in the 1980s. Europe recovered after WW II not because of American subsidies but because of the liberal economic policies of Ludwig Erhard, who opposed the price controls championed by the socialist J.K. Galbraith.

So job one in aiding the developing world should be to improve their institutional infrastructure, and to oppose NGOs and their faux(en) aid. To the extent that this happens, private capital will flow to these places, their markets will grow, and the standard of living of the locals will improve.

As the Birchers used to say, "Get us out of the UN." And get the UN out of the US!

A lack of capital is far easier to solve because, if they think that they'll get paid back, the lenders will come to you!

I was in Asia in the mid-1990s and saw how eagerly businessmen from around the world would grovel at the feet of Southeast Asians (and worse, communist Chinese), begging to be allowed to invest. When China offered a promised 18% - 20% return, power companies were flocking to China to do 20 year build-operate-transfers, where the builder would fully finance the power plant and would get paid back only from sales of the output for 20 years, after which the plant would be transferred "as is, for no consideration" to the local government. This was for plants with an expected life of 50 years. And let's face it, China was and is far from being a low risk investment.

So, for a promised return of 18% (or maybe less, now that interest rates are lower), companies will fully finance developing country infrastructure projects (power plants, roads, bridges, water and sewage treatment, etc.) and will get them up and running in a short amount of time. And for countries that need infrastructure and are ready to develop, such returns are a bit high but not impossible. The catch is that the businesses want a reasonable chance of being paid back.

When I was young, my father didn't have enough money at the start of the farming season to buy seed or fertilizer. He would go down to the small town bank, and they would loan him several hundred dollars just on his handshake. He would pay it back out of the farm profits a few months later.

That system had been in place for decades. It still exists in some parts of the country. The banker has to know the farmers in order for it to work. Capital is not the problem. There were no institutions involved, to speak of, either. Just trust between two humans. That's all you need for a successful -- and profitable -- business transaction.

The lack of capital is much easier to solve, for the reasons mentioned above. But when Bob Knaus says there were "no institutions involved" in the scenario he described, he's ignoring that the bank and even the framework of trust that allows such loans is, in fact, an institution.

I think it's discouraging that the knee-jerk reaction to corruption and institutional problems is to withdraw capital from developing markets. In the final sentence of the Daley and Hooks selection, for example, they argue donors should withdraw funding until these institutional problems are addressed. This would obviously result in funding for worthy programs drying up while the corruption would continue. Even given the problems of the Oil-for-Food program, I doubt if there are many people who would rather that the program never existed. It is the more difficult issue of 'institutional deficiencies' that must be addressed while somehow sustaining the capital flows. I would be interested to see a study which examined how corruption increased or decreased proportionately to capital inflows. For example, if the donors give less, do the corrupt simply siphon off a larger piece of the pie? Or, to what degree do the bribes become larger as capital inflows increase? Does anyone know of concrete examples?

Bob hit on a very important point. Faith (the handshake) is the catalyst for productivity. Good faith equals stability and fair profits. Bad faith equals instability and inequitable profits. Laws/contracts/institutions provide a mechanism for redress when faith is broken but there is always a net loss of productivity when people have to resort to courts (institutions) to get what they were promised.

I think that capital is easier to come by because capital is just a representation of proportional inequality (not necessarily bad) which exists no matter the time, place, or economy. The difficult thing in some cases is amassing enough inequality (capital) to produce potential energy or healthy volatility. Institutions follow as faith collapses between individuals.

Matt was right about the bank being an institution but he's arguing degrees of complexity. It's not the presence of an institution but the character of the institution that makes a social order possible. A handshake is much simpler than the loans I deal with every day. Institution? Yes. Barrier? Not so much.

We should get beyond the chicken and egg puzzle. How can we take a snapshot then evaluate and normalize deficient economies? How do we restore faith where none exists? The only way I've seen involves a lot of blood and homogeneity (REVOLUTION). Not a pleasant way to go.

Capital is easy to generate whether within or without. What is hard to combat is the structural Cultural bias. The Elites are adverse to change in economic structure, unless they can understand and profit from such Change. lgl

The comments by Bob Knuas about the bank loans for small farmers is looking at the end result of a whole host of institutions that exist to make what seems a simple transaction possible.

At one time such a loan would have been a "call" loan that events in NY or Europe could force the bank to become inliquid and call the loan at a bad time for the farmer and ruin him. But, the govt by inventing the Federal Reserve and other institution --after much trial and error -- managed to create a much more stable financial environment that allowed the bank make a much more rational type of loan to the small farmer.

So what Knaus sees, is the product of a massive set of social-economic institutions that he barely touches on and generally ignores.

I agree with previous commentators that capital problem will be easy to solve. One thing that is missing out from the discussion, as well as from the lead piece, is how microfinance evolved to solve a problem of market failure. Commerical banks are unwilling to provide collateral free loans to poor people because they do not own land and the transaction cost of managing small loans are high. Besides there are issues of asymmetrical information. Microfinance solved the problem by letting the borrowers monitor each other. It also solved a collective action problem--lack of trust in the poor peoples ability to repay loans. De Soto oversells the idea that titling of land will solve all the problems. Even in his own Peru, titling does not increase access to credit. See,
http://www.slate.com/id/2112792/#ContinueArticle
In South Asia, the poorest of the poor can be identified easily by looking at the hoardes of them who does not own any land.

The bottom line is microfinance solved a problem of "market failure". One could say that it solved an institutional failure as well.

The Slate article was very interesting. I wonder if the failure to actually make De Soto's ideas work on the ground was due to a poorly designed implementation or if it was because de Soto got the cart before the horse. Perhaps formal property rights are caused by a developing economy rather than the reverse!

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